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1.The yield of a one-year bond this year equals to 6.5%, and people expect the yield of a one-year bond to remain the same on the second year but fall to 5% on the third year. Also, people also require a 0.25% term premium for each additional year of bond maturity.
a. Calculate the yield of a two-year bond and a three-year bond according to the theory of liquidity premium. Compare the yields of the three-year bond, two-year bond, and one-year bond, what does it tell you about the shape of the yield curve?
b. Calculate the yield of a two-year bond and a three-year bond according to the expectations theory. Compare the yields of the three-year bond, two-year bond, and one-year bond, what does it tell you about the shape of the yield curve?
Assume that there will be a 2% (200 basis points) increase in the market interst rate one year from today. Calculate what the price, current yield and the yield to maturity for the bond one year from today following the rate increase.
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